Wednesday, December 18, 2013

Leveraged dividend growth investing

One of the assets that a typical middle class person owns is their house. Houses are purchased with approximately 20% down or less. People usually get a mortgage for the remainder, and they pay the credit off for 30 years. The house provides shelter to the family that purchased it, and hopefully its price keeps up with inflation. Houses however cost a lot of time and money, including renovations, property taxes etc.

With stocks however, regular investors rarely go into debt to purchase partial ownerships of companies. This could be attributed to several factors such as lack of desire to invest in stocks in the first place, the lack of understanding of margin and the higher interest rates paid on stocks with borrowed money. Dividend stocks on the other hand pay you money and you can offset interest expense against dividend income.

Stocks are usually valued mark to market in a brokerage account. If they fall in value the broker would require more money as collateral. This is the dreaded margin call where we either need to add more money or the broker would sell your position. Stock prices fluctuate daily, and as a result if one were to invest $1000 in shares of Procter & Gamble (PG), and bought $1000 more on margin they could end up with nothing if the stock price fell by 50%. If your house value fell by 50%, the mortgage company wouldn't require more money as collateral. They would not repossess your house, unless you are really late on your payment.

Another reason why investing with borrowed money is not popular is because interest rates on margin loans are usually very high. Many brokers charge over 6% presently, which is very high in the current interest rate environment. Only a few brokers, such as Interactive Brokers have margin rates at around 1%. In addition, margin interest rates are also not fixed, but variable. While interest rates are expected to remain low until 2014 - 2015, an increase in the benchmark rate would likely increase the cost of interest rates on margin loans. This could reduce investor returns as a result.

By using borrowed money to purchase dividend stocks, investors can magnify their dividend income significantly. For example, an investor with $100,000 in dividend paying stocks yielding 3% will generate $3,000 in annual dividend income. If they were to buy $100,000 in dividend stocks on margin, they would end up paying around 1.67%/year to a broker like Interactive Brokers, and increase dividend income to $4,330/year. This strategy can work for investors in the accumulation phase, as it could speed up the accumulation of dividend paying shares and compounding of dividend income.

In order to minimize risks mentioned above, an investor should use an adequate margin of safety with leveraged dividend investing. This would means that they should not borrow more than 25% – 30% from their account for margin investments. This would protect the investor from margin calls even if stock prices fell by 50%.

In addition, investors in the accumulation phase should have a plan to pay off their margin loans from their expected monthly contributions to their portfolio within 4- 5 years.

For example let’s assume that our investor with the $100,000 portfolio plans on adding $12,000/year for the next five years. This means that if they purchased $25,000 on margin, they could pay it off within 2 years simply by sticking to their regular investment schedule. However, by using a low cost margin loan, they would be accelerating their dividend compounding process.

In my personal portfolio, I sometimes purchase shares on margin when I see good values in the market. For example, if my portfolio was worth $100,000, and my lot size was $1,000, I might spend $2,000 - $3,000 on 2 – 3 stocks that looked attractive. I would then pay off the margin in a few weeks. I always pay my margin within a couple weeks however, as I use it to scoop up shares that are temporarily beaten down, while waiting for my paycheck to get deposited.

In the past month, I purchased shares of Target (TGT) and Becton Dickinson (BDX) on margin. However, as of this time, the margin has been repaid.

Target Corporation (TGT) operates general merchandise stores in the United States. This dividend champion has rewarded shareholders with higher dividends for 46 years in a row. Over the past decade, Target has managed to raise dividends by 18.60%/year. Currently, the stock is attractively valued at 16 times earnings and yields 2.60%. Check my analysis of Target for more details.

Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. This dividend champion has rewarded shareholders with higher dividends for 42 years in a row. Over the past decade, Target has managed to raise dividends by 16.80%/year. Currently, the stock is attractively valued at 16.70 times earnings and yields 2%. Check my analysis of Becton Dickinson for more details.

I am also playing around with Loyal3, which lets you buy shares with a credit card, commission free. If you time your monthly purchases there, you can essentially get an interest free loan for almost 6 - 8 weeks, while also earning credit card rewards points. In addition, Loyal3 allows investors to buy shares with as little as $10 per each investment.

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